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Mark Zuckerberg invited you to: Facebook’s IPO

*If you are new to this topic, I would suggest reading the “terms-to-know” section at the bottom of the page before you start.

It’s quite amazing that within seven short years, Mark Zuckerberg’s Facebook has reached a valuation (according to private secondary markets) of over $100 billion. It’s hard to believe. But, then again, is it really? According to Facebook’s initial public offering (IPO) filling, there are currently 850 million active monthly users. Facebook has become a place where friends and family can communicate, gossip, and essentially share every last detail about their lives through “likes,” “relationship statuses,” “event invitations,” etc. We spend a total of 12 billion hours per month on Facebook (I know, it blows my mind too), 20 million apps are downloaded every day, and more than half of employers actually use social networks to research potential job candidates (1).

As of March 30, Facebook has seen its highest implied valuation to date: $102.8 billion, that’s 25 times 2011 revenues, impressive to say the least, but how do we get to this number? Well given its $44.10 share price on the secondary market and assuming about 2.33 billion outstanding shares, we arrive at a value of $102.8 billion. Earlier this month, the company halted the sale of its shares on the secondary market in order to prepare for its IPO in May when it hopes to raise about $5 billion.

So of course the overplayed question of the year arises: is Facebook really worth what the market is saying its worth? Truth be told, your guess is as good as mine. Without getting into too much technical detail, there is honestly countless ways to value the company and all the methods I’ve come across so far take a different perspective on Facebook’s growth. Analysts on the street have been arguing back and forth for months on what a reasonable price target is for the company, but as it stands right now, the bulk of the opinions give Facebook a valuation of anywhere from $75 to $100 billion.

Personally, I’m a huge proponent of Facebook and I do believe that it’s an incredible company. However, just because it is an incredible company doesn’t necessarily mean that it’s worth over $100 billion.

Let’s take a crude approach on analyzing the value of Facebook. When assessing the value of the company, we need to look at three important things: the earnings, the multiple (what the market perceives it should be paying for those earnings), and the future growth rate and trend.

Earnings: Facebook earned $1 billion in 2011.

Multiple: In this case, we’ll be using the P/E ratio. To get an idea of what kind of P/E ratio we should use, we can look at other fast-growing and highly successful tech companies such as Google and Apple.

But let’s think about this one. Given Facebook’s earnings of $1 billion, a Google-esque P/E ratio would suggest a value of about $19 billion. But of course, we know that Facebook is currently growing faster than Google and Apple, so let’s instead assume a higher and much more impressive multiple of about 60. That still places the company’s value at only $60 billion. The final thing we need to consider is future growth because market valuations are a representation of what we expect future performance to be. Unfortunately, this is the most difficult part to predict accurately.

Future growth rate and trend

The question everyone wants the answer to is how fast Facebook’s earnings will grow over the next few years. The market generally rewards companies whose earnings are growing fast and accelerating with higher multiples. So that may be where one could justify a multiple of 60 or in Facebook’s case, given its current valuation, a multiple of over a 100. But let’s be realistic here, Apple, the world’s largest company has a P/E ratio of only 17. This is the company that has continuously beat analyst estimates and is even considered by some to reach a $1000 share price.

To me Facebook’s $100 billion price tag just seems too aggressive and requires too many assumptions. Most analysts point towards Facebook’s huge growth potential abroad, which heavily relies on an entry into the Chinese market. Facebook is trying to penetrate that market, but as of right now, they aren’t getting anywhere. The bulk of the Facebook’s valuation must lie in its most important asset, its database of users. If you ask me, I’ve never seen something more difficult to value. Facebook holds one of the most important and valuable databases in the world and in the long run, its how they use this database that will truly determine its profitability. The company needs to find some way to further monetize its mobile traffic and user base, which according to some analysts can be by integrating ads into news feeds. Ultimately, we’ll just have to wait and see what they do.

I hate to be a debbie downer because I do admire Facebook and its business model, but if you’ll allow me to put on my skeptic hat on just one more time, I have to bring your attention to Yahoo!’s IPO 11 years ago. In the initial stages following the IPO, the share price reached a high of $150 a share and everyone at the time was talking about how it was the “future of the internet.” At the moment, Yahoo’s shares sits at a measly $15. It’s simply a reminder that there have been companies in the past that people believed would revolutionize the industry but unfortunately, that doesn’t always mean that you’ll be profitable. In the case of Facebook, there is a lot to be said so stay tuned for another post following the IPO where I’ll try to decipher what I think are and will be the main drivers of Facebook’s growth going forward.

And of course, if you have any questions, please feel free to contact me directly at Mohammed.Islam@tufts.edu.

*Note: the basic analysis that we did on Facebook’s valuation earlier gives us an estimate of what we think the stock is actually worth, not what the stock will trade at when it goes public. Facebook clearly has a lot of hype surrounding it, so these two numbers will inevitably be different. However, one thing to remember is that stock prices do eventually reach their intrinsic value.

Terms-to-Know:

Initial public offering (IPO) - The first sale of stock by a private company to the public. IPOs are often issued by smaller, younger companies seeking the capital to expand, but can also be done by large privately owned companies looking to become publicly traded.

P/E ratio - A valuation ratio of a company’s current share price compared to its per-share earnings.

Calculated as:

Market Value per Share/Earnings per Share (EPS)

For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).

One thought on “Mark Zuckerberg invited you to: Facebook’s IPO”

Great piece, thanks for sharing. One thing that could be worthwhile to look at would be the P/E ratio of the other companies when they first had their IPO. That way you could get a more apples to apples comparison since you’d be comparing the companies around similar stages in their lifetime. I’m guessing that Google, Amazon, and others had similar high P/E ratios when they launched, but as you mentioned the market has had years to fairly value the companies – and the companies have had years for their earnings to come to higher, and more predictable, levels. Maybe in a future blog post!

It is interesting that Apple is valued relatively conservatively when it has a demonstrated track record of delivering on sales and earnings, yet Facebook is valued so high with little to no track record. But I do see a lot of potential for facebook if they can monetize their user base, which I’m betting that they eventually will. Data is becoming increasingly valuable and I’m sure they’ll find innovative things to do with it. Cheers,